Hedge Funds Meet Their Match

CAN THE MASTERS of the universe save themselves?

Hedge fund managers, the stars of the investing world for most of this decade, were brought to their knees in the turmoil of 2008. The average fund fell far short of its goal of "absolute returns," posting an 18% loss through November. Old standby strategies, such as buying some stocks and selling others short, suddenly stopped working. Customers bolted in record numbers. Then, at year's end, the industry got a black eye for putting money in Bernard Madoff's black box.

"The hedge fund is being questioned, and it's in danger," says Timothy Brog of Locksmith Capital Management, an activist New York hedge fund.

Indeed, the industry is moving into survival mode for 2009 — and many funds won't make it. The number of hedge funds, which surged in recent years to an estimated 10,000, could eventually fall to about half that, as small, marginal players are sold or go out of business.

The survivors will no longer be able to rely on leverage to goose returns, thanks to the credit crisis. They'll have to prove that they seriously investigate potential investments. And they will have to make their own operations considerably more transparent. All the while, regulators are sure to be watching over the industry with new vigor.

Unquestionably, hedge funds will have a tougher time winning the outsized returns — and profits for themselves — for which they became famous in recent years. But that hardly spells the end of the industry.

"We contend that the hedge-fund story is bruised but still alive," Christopher Miller, chief executive of Allenbridge Hedgeinfo in London, recently wrote. "Certainly many clients have been so badly hit that they never intend to invest with (insert name of just about any manager) again, and it will take a while before they trust the asset class at all."

To their credit, hedge funds did beat the broad market last year; the Standard & Poor's 500 fell by some 38%. But that's not an accomplishment the industry can easily ballyhoo. After all, hedge funds long have promoted themselves as vehicles for making money in any kind of market, thereby preserving capital. By simply measuring themselves against the market, hedge funds start to look like mutual funds, and mutual funds charge much lower fees.

For long/short funds, those industry staples that not only buy stocks but also bet on declines, the big problem last year was on the long side; the huge majority of stocks went down. In the 2000-2002 bear market, by contrast, there was much greater dispersion among stocks. Hedge funds as a group almost broke even back then, while the broad market was off 22%.

Long/short was by no means the only hedge-fund strategy to fail last year. Convertible arbitrage, which entails buying convertible securities and short-selling the related stocks, racked up losses of nearly 50%, according to Dow Jones indexes. And investing in distressed securities produced average losses of 37%.

Investors could scarcely get out fast enough. As of Oct. 31, the industry's net redemptions for the year totaled a startling $43.5 billion, versus a net inflow of $194.4 billion in 2007. It was by far the largest withdrawal since Hedge Fund Research began tracking the field in 1990.

In all, 2008 was "the worst year in terms of performance and capital flows that we've seen," says Kenneth Heinz, president of HFR. "It clearly extends into '09. The question is how far into '09 it extends."

Michael Singer, co-president of alternative asset manager Ivy Asset Management, says that those redeeming their hedge-fund holdings are largely high-net-worth investors, endowments and foundations. He adds, "High-net-worth investors were spooked and want to own Treasuries and to wait it out, probably for a year."

Singer estimates that the entire hedge-fund industry's assets will have shrunk from roughly $2 trillion to around $1.25 trillion by the time the shakeout is over, with big funds generally faring the best.

For one thing, heft helps giants like Caxton and Farallon ride out stretches of poor performance. Big funds are better positioned to pay for extensive due diligence on investments — a task investors will increasingly value in the wake of the Madoff scandal.